SBUX: A Well-Timed Transaction

Yesterday, Starbucks announced that it will acquire the remaining 60.5% share of Starbucks Japan in a two-step tender offer process that should be fully completed in the first half of calendar 2015.

There are two ways to view this transaction.

On one hand, this is good news for shareholders. Japan is a large market for Starbucks accounting for approximately $1.2 billion in revenues, boasts high store-level profit margins (20-25%) and will immediately be accretive to adjusted EPS, although to what extent is unknown. Longer-term, this makes strategic sense as well as it will allow the company to capture the significant growth opportunity left in that region.

One the other hand, however, we believe the timing of the deal confirms our view that growth in the core business is slowing. The company could've done this deal at any time in the past three years, but did not need to given strong sales trends and a significant commodity tailwind. With these trends reversing, expectations for 18% EPS growth in FY15 looked aggressive, at the very least.

On the call last night, management said they would update FY15 guidance when they report earnings in late October. Given the immediate accretion from the deal, 18% EPS growth next year now looks achievable and we suspect they will move guidance from the low-end to the high-end of the 15-20% range. Given aggressive estimates for next year, it is comforting to know that they will, in all likelihood, not be revised higher from here. Another important point is that this acquisition will, for now, help mask the margin decline that the company was facing.

Despite this news, if the core of our thesis is right (same-store sales decelerating, commodity costs increasing), it will have a bigger impact on the stock than this well-timed transaction.

Call or email with questions.

Howard Penney

Managing Director

Fred Masotta

Analyst

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09/24/14 09:16 AM EDT

Two Chip Stocks to Key In On as Skittish Investors Rotate Into Large Cap Liquidity

In a macro environment where skittish investors are rotating into the largest capitalization stocks, Hedgeye Semiconductors sector head Craig Berger discusses why he like Texas Instruments (TXN) and Qualcomm (QCOM) as the top mega-cap stocks in his sector.

LEISURE LETTER (09/24/2014)

EVENTS

Sept 24: 9 a.m. Revel Auction

Sept 24: MTN 11:30 am FYE 2014 Earnings Call

Sept 24: Hedgeye Snakeye in Las Vegas

Sept 29 - Oct 2: G2E Las Vegas

COMPANY NEWS

IGT, GTK AMEND MERGER The amount of stock and cash to be paid to IGT shareholders is unchanged. However, the amendment eliminates the option for shareholders to elect an all-stock, all-cash consideration. All IGT shareholders will receive a combination of $13.69 in cash plus a number of shares in the new GTK, which will be equal to $4.56, divided by the dollar value of GTK shares prior to the deal closing.

Takeaway: This reduces the regulatory and disclosure requirements needed to complete the merger.

BYD – launched a new sports wagering application for mobile devices, allowing customers in Nevada to bet on college and professional games and events.

Takeaway: Boyd taking the next step in on-line gaming, but not likely to impact earnings.

IGT – Maryland has added a new game to its casinos, the "MegaHits" multi-state, progressive jackpot. Maryland is the fifth state approved by the Multi-State Lottery Association to participate, joining Delaware, Ohio, Rhode Island and West Virginia. The game will be available at Maryland Live! in Hanover, the Casino at Ocean Downs in Berlin and Hollywood Casino in Perryville. Megahits is a slot machine game played at selected casinos in the five states. Jackpots range from $100,000 to seven figures, with bets available in penny and dollar denominations.

Takeaway: The multi-state MegaJackpot link should help IGT

WYNN – Mixed messages regarding the investigation into the Wynn Cotai land transaction. GGRAsia is resporting “The relevant investigation is still underway,” the city’s Commission Against Corruption told GGRAsia on Wednesday. However, On Tuesday, Steve Wynn said the investigative team was satisfied with the information the company had provided on the deal and he further said he believed the investigation had been concluded.

Takeaway: In Macau, nothing is ever approved or closed until the governing agency or bureau says so.

HLT – announced Hilton HHonors, the loyalty programme for Hilton Worldwide’s 11 distinct hotel brands, a new partnership with AirAsia BIG. The partnership allows members of both AirAsia BIG and Hilton HHonors to earn BIG points and HHonors points when they stay at any of the more than 4,200 hotels and timeshare properties within the Hilton worldwide portfolio around the globe, said the companies in a joint statement.

Takeaway: Hilton building out its cross marketing relationships in an effort to promote guest visits to its growing platform of Asian hotels.

MHGC – Activist investor Ron Burkle announced his intention to nominate a board member following the resignation of Derex Walker.

Takeaway: Burkle keeping the heat on MHGC.

INDUSTRY NEWS

Cotai Construction Worker Transportation – (Macau Business) The Transport Bureau and three unidentified gaming companies are discussing the use of shuttle buses to take construction workers that live in the mainland from the Border Gate to their workplaces in Macau, according to the director of the bureau, Wong Wan.

Takeaway: The gaming operators attempting to make good with the Chief Executive as well as workers.

Macau Smoking Ban Investigation – (Macau Daily Times) Lawmaker Lei Cheng I and her colleagues from the Macau Federation of Trade Unions (FAOM) met with department heads from the Health Bureau (SSM) and the Gaming Inspection and Coordination Bureau (DICJ) yesterday to discuss the control of smoking inside casinos. The lawmaker requested government official to personally inspect the casinos and determine if the casino operators are trying to exploit a legal loophole, enlarging their smoking areas by partially converting their mass areas into VIP areas.

Takeaway: More pressure on the Health and Gaming Inspection and Coordination Bureaus to address the smoking ban concerns and safeguard the health of the gaming floor workers.

Hong Kong National Day Tourism – (SCMP) Hong Kong Inbound Tour Operators Association chairman Ricky Tse Kam-ting said the number of bookings so far was only half of last year's total, and assuming some last-minute bookings, he expected the total to be down 30%. The Chairman noted "There are a lot of good hotel deals in Malaysia [after two tragedies involving Malaysia Airlines planes]. The same goes for Thailand, which is rolling out bargains after political turmoil."

Chinese Tourism for Golden Week – (SCMP) The China Tourism Academy predicted that 480 million people would be holidaying during the period, an increase of 13% year-on-year

Takeaway: A positive trend, but Macau needs to capture some of this increase in tourism.

Cyprus Casino Draft Legislation – The Cypriot Government published the a draft of the law for a proposed integrated resort which include:

The law provides for a casino of international standard, and a hotel or hotels of international standards exceeding the requirements for a five-star establishment under existing laws with at least 500 luxury rooms, at least 100 gaming tables and at least 1,000 gaming machines.

Under the provisions, the operator can create four other premises ‘off-site’ with a maximum of 50 gaming machines per premises but no casino games. These premises must be located outside the district where the resort is based but cannot be sold, rented, transferred or assigned to anyone other than the resort operator. The integrated resort can stay open 24 hours a day, seven days a week and smoking will be allowed on the gaming floor.

The initial fee for the casino resort will be determined as part of the initial offer for the 30-year license with 15 years of exclusivity for the operator. The annual fee to the state each year for the first four years will be €2.5 million, rising to €5 million for years four to eight, after which it may be reviewed upwards by the Cyprus Gaming and Casino Supervision Authority (CGC).

On top of that, the government hopes to pick up 15%, a casino tax, from gross gaming revenues per month.

The supply of gaming services – to be defined by inland revenue – will be VAT-free but the rest of the resort’s facilities will not be exempt.

Takeaway: Looks like a decent opportunity for suppliers but may be scaled down.

Singapore Punter Exclusion Broadens – (GGRAsia) Twenty-three non-casino gambling operators on Tuesday joined Singapore’s centralized self-exclusion scheme, which now covers social clubs with jackpot machines and sports betting clubs. Twenty-three of the city's seventy-three non-casino gambling operators on Tuesday joined Singapore’s centralized self-exclusion scheme, which now covers social clubs with jackpot machines and sports betting clubs. As of August 31, there were over 500 active non-casino self-exclusions, as compared to the 165,000 active self-exclusion applications covering casinos.

Takeaway: Singapore taking a stance on problematic gambling beyond the two integrated resorts.

Singapore Consumer Confidence Slightly Higher – In the latest ANZ-Roy Morgan Singapore Consumer Confidence Index survey, 27% of respondents said their family are better off financially now than a year ago, higher than the 20% in the previous survey, 33% expect their family to be better off financially in a year's time, up from 28% previously; however, 12% of respondents think they are now worse off financially than a year ago, also rising from the 8% in the previous survey.

Takeaway: While confidence is higher, it may not translate into a higher gaming budget, with so many restrictions surrounding the IRs.

Mixed fortunes for Genoa (Seatrade Insider)

After a record 1,050,085 passengers in 2013, Genoa’s Stazioni Marittime is expecting just over 800,000 passengers on around 200 calls this year.

Takeaway: European port gives a conservative outlook for 2015.

MACRO

Hedgeye remains negative on consumer spending and believes in more inflation. Following a great call on rising housing prices, the Hedgeye

Macro/Financials team is turning decidedly less positive.

Takeaway: We’ve found housing prices to be the single most significant factor in driving gaming revenues over the past 20 years in virtually all gaming markets across the US.

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09/24/14 09:01 AM EDT

Retail Callouts (9/24): KSS, BBBY, TGT, WMT, Holiday Sales

Takeaway:KSS Short call at 11am. BBBY finally turns – how long will it last? TGT.ca going heavy on price. Deloitte Holiday survey bullish, as always.

This is the first solid print for BBBY in a very long time. For those (including us) who missed the event, we'd simply ask...if BBBY could disappoint repeatedly for the better part of two years, why should we assume that the positive turn lasts only one quarter? The company took up numbers, but our sense is that there's a lot more room to go. We're adding this one to our long bench -- need to dig in to gauge additional upside.

"Target Canada is aggressively repositioning to drive its price value, according to a basket pricing study by Kantar Retail."

"'Target’s price leadership in Canada has clearly shifted,' noted Robin Sherk, director of retail insights, Kantar Retail, and contributor to the study. 'We found that the price of Target Canada’s overall basket was 3.9% less expensive than Walmart’s. In our initial study, the retailers’ basket values were effectively even.'"

Takeaway: This might very well be the right move for Target Canada, as it needs to dramatically improve traffic to it's stores. But we can't shake the concern that a) in the end, Wal-Mart will not lose on price...even if it sells product below cost, and b) winning on price is a strategy of last resort. We want to see Target win on assortment, or value-add, or customer experience, or some other factor that sets it apart from the competition. Once you go become a price leader, or attempt to, there's really no going back.

"U.S. retail sales may increase as much as 4.5 percent this holiday season, exceeding last year’s gain, as improving incomes and job prospects encourage consumers to open their wallets, according to Deloitte LLP."

"Sales, excluding purchases of motor vehicles and gas, may climb to as much as $986 billion in November through January, Deloitte, a New York-based consulting firm, said today in a statement. Holiday sales by that measure rose 2.8 percent last year, according to the company."

Takeaway: These forecasts are interesting, but we can't really use them. Deloitte historically has proven that it does not know how to forecast a sales number outside of a band of 3-5%. It was right in 2012, when sales in Nov/Dec grew by 3.6%. But its' 2013 forecast of 4-4.5% was a bust, with sales only growing 1.9%. Let's not forget that this group is part of the organization that is the auditor for a couple dozen major retailers, including Best Buy, Gap, Sears, Dick's, Nordstrom, Coach and Toys R Us. We're not saying that results are compromised, but it's certainly not incentivized to tell the world that the holiday sales outlook is bad.

"German unions are accustomed to wielding formidable influence. Union officials sit on supervisory boards at blue-chip companies. They have a track record of wearing down foreign employers."

"Not so at Amazon.com Inc. For the 16 years the online retailer has done business in Germany, it has shunned the nation's consensus-driven labor model. It ignores trade unions and largely dictates contract terms at its nine German distribution centers, where it employs about 9,000."

"As part of its holiday strategy, Toys"R"Us plans to hire 45,000 seasonal employees at its stores and distribution centers nationwide, more than doubling the company's workforce as it continues preparing for the highly contested shopping season ahead."

"REI announced that Annie Zipfel has been promoted to senior VP marketing. With her, REI will not hire a chief marketing officer as previously announced, but instead add a senior creative leader to the company."

"PayPal has made its first direct entry into the virtual currency space. The company announced via a blog post that it has entered into agreements with leading Bitcoin payment processors BitPay, Coinbase and GoCoin. The agreements let PayPal’s digital goods merchants in North America accept Bitcoin, with a simple integration through the PayPal Payments Hub."

"RadioShack Corp. has reportedly so far been unsuccessful in its efforts to convince an unidentified ‘major vendor’ to modify a commercial agreement in a way that could benefit a financial restructuring. According to the Wall Street Journal, RadioShack still has not identified the vendor or exactly what terms it wants to restructure, but has been negotiating with wireless carriers including AT&T and Sprint to ease the terms under which the retailer is allowed to resell equipment."

"Victoria Beckham has built a dream space on Dover Street in London, her first store and 'second home' in Mayfair, where she can express her vision on the shop floor. The 6,040-square-foot space spans three floors, and has more in common with a contemporary art gallery than a typical London luxury flagship."

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09/24/14 08:31 AM EDT

Volatility, the Consumer and China

Client Talking Points

VIX

Same #process, buy equities at the low-end of their risk range and high-end of volatility’s. The VIX risk range is now 13.13-14.99; this is not for the faint of heart, as total macro volatility comes off its most asymmetric low, ever.

U.S. CONSUMER

As in Discretionary (XLY) stocks got pounded back to flat for 2014 year-to-date yesterday; this was a sector a lot of people chased on the “down oil” thing, but its down -2.7% for the month – down oil isn’t going to change the all-time high in U.S. cost of living. Commodity deflation is setting in, but pricing is sticky.

CHINA

The only real good equity news in the last 48 hours was Chinese stocks ripping fresh year-to-date highs, up another +1.5% overnight to +14.4% year-to-date for the Shanghai Comp, running neck and neck with our preferred way to be long of U.S. #GrowthSlowing, the Long Bond (TLT) +14% year-to-date.

Asset Allocation

CASH

46%

US EQUITIES

4%

INTL EQUITIES

12%

COMMODITIES

4%

FIXED INCOME

30%

INTL CURRENCIES

4%

Top Long Ideas

Company

Ticker

Sector

Duration

EDV

The Vanguard Extended Duration Treasury (EDV) is an extended duration ETF (20-30yr). Now that we have our first set of late-cycle economic indicators slowing in rate of change terms (ADP numbers and the NFP number), it's time to really think through the upcoming moves of this bond market. We are doubling down on our biggest macro call of 2014 - that U.S. growth would slow and bond yields fall in kind.

TLT

TLT:

Fixed income continues to be our favorite asset class, so it should come as no surprise to see us rotate into the Shares 20+ Year Treasury Bond Fund (TLT) on the long side. In conjunction with our #Q3Slowing macro theme, we think the slope of domestic economic growth is poised to roll over here in the third quarter. In the context of what may be flat-to-decelerating reported inflation, we think the performance divergence between Treasuries, stocks and commodities may actually be set to widen over the next two to three months. This view remains counter to consensus expectations, which is additive to our already-high conviction level in this position. Fade consensus on bonds – especially as growth slows. As it’s done for multiple generations, the 10Y Treasury Yield continues to track the slope of domestic economic growth like a glove.

RH

Restoration Hardware remains our Retail Team’s highest-conviction long idea. We think that most parts of the thesis are at least acknowledged by the market (category growth, real estate expansion), but people are absolutely missing how all the pieces are coming together to drive such outsized earnings growth over an extremely long duration. The punchline of our real estate analysis is that a) RH stores could get far bigger than even the RH bulls seem to think, b) Aside from reconfiguring 66 existing markets, there’s another 19 markets we identified where the spending rate on home furnishings by people making over $100k in income suggests that RH should expand to these markets with Design Galleries, and c) the availability and economics on large properties for all these markets are far better than people think. The consensus is looking for long-term earnings growth of 28% -- we’re looking for 45%.

Risk Managed Long Term Investing for Pros

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